Lacker says government should be ready to let big banks fail

Federal Reserve Bank of Richmond President Jeffrey Lacker said plans to limit the size or change the structure of the largest financial institutions must be made with the intent of allowing a failure without government aid.

“It makes perfect sense to constrain the scale and scope of financial firms in a way that ensures that they can be resolved in an orderly manner, without government protection for creditors,” Lacker said.

U.S. regulators and lawmakers are searching for ways to limit the risk that a large bank failure will result in another taxpayer-funded bailout. Senate Republicans and Democrats are discussing legislation that would boost capital standards, while Fed officials are discussing ways to limit the safety net and curb balance-sheet expansion at the largest banks.

While the Dodd Frank Act’s preamble says its intent is to “end ‘too-big-to-fail,’” some of the largest banks may still benefit from the perception that they would be rescued by the government, Federal Reserve Chairman Ben S. Bernanke told lawmakers in February.

“We need to be working in the direction of eliminating it entirely,” Bernanke told the House Financial Services Committee on Feb. 27.

The Dodd-Frank Act required firms to write living wills, or plans that describe how they would be wound down in the event of failure. Lacker said one flaw in the law is that it has provisions for temporary government support.

‘Credible’ Plan

Lacker advocated “creating a credible funding plan that avoids adverse effects, without resorting to government” financing “might seem daunting,” Lacker said at the University of Richmond.

“I see no other way to achieve a situation in which policy makers consistently prefer unassisted bankruptcy to incentive-corroding intervention and investors are convinced that unassisted bankruptcy is the norm,” Lacker said at the University of Richmond.

The KBW Bank Index, which tracks the shares of 24 large U.S. banking companies, rose 8.7% this year through yesterday, compared with a 9.6% gain for the Standard & Poor’s 500 stock index.

Fed Governor Daniel Tarullo said Congress should consider a cap on non-deposit liabilities to curb balance sheet growth at the largest banks. Dallas Fed President Richard Fisher proposed that the central bank provide backup liquidity to commercial banks alone and not any of their nonbank subsidiaries.

Banks have boosted capital levels since the crisis as regulators demand larger buffers against loss. Bernanke said the aggregate Tier 1 common equity ratio at the 18 largest banks rose to 11.3% at the end of 2012 from 5.6% of risk-weighted assets at the end of 2008.